Case Scenario:
Mary and Nick Stalcheck have an investment portfolio containing 4 vehicles. The portfolio contains common stock, industrial bonds, mutual fund shares and options. They are interested in measuring the return on their investment and assessing how well they have done relative to the market. They hope that the return earned over the past calendar year is in excess of what they would have earned by investing in a portfolio consisting of the S&P 500 Stock Composite Index. Their research has indicated that the risk free rate was 7.2% and that the (before tax) return was 10.1% during the past year. With the aid of a friend, they have been able to estimate the beta of their portfolio, which was 1.20. In their analysis, they plan to ignore tax and all of their investment have been held more than 12 months and would only consider unrealized capital gains. To make necessary calculations, they have gathered the following information on each of the 4 vehicles in their portfolio.
Common Stock- They own 400 shares of KJ Enterprises common stock. KJ is a diversified manufacturer of metal pipe and is known for its unbroken stream of dividends. It share price has risen from 17.25 at the start of the last calendar year to 18.75 at the end of the year. During the year, quarterly cash dividends of .20 ,.20, .25, and $.25 were paid.
Industrial bonds- They own 8 Cal industries bonds. The bonds have a 1,000 par value and have a 9.250% coupon and are due in 2018. They are A- rated by Moody's. The bond was quoted at 97,000 at the beginning of the year and ended the calendar year at 96.375%.
Mutual Fund- They hold 500 shares in the Holt Fund, The dividend distributions on the fund during the year consisted of $.60 in investment income and $.50 in capital gains. The fund's NAV at the beginning of the calendar year was $19.45, and it ended the year at $20.02.
Options- They own 100 options contracts on the stock of a company they follow. The value of these contracts totaled $26,000 at the beginning of the calendar year. At the year end the total value of the options contracts was $29,000.
Questions to answer:
Q1. Calculate the holding period return on a before tax basis for each of these 4 investment vehicles.
Q2. Assuming their ordinary income is currently being taxed at a combined tax rate of 38%. And that they would pay a 15% capital gains tax on dividends and capital gains for holding periods longer than 12 months, determine the after tax HPR for each of their 4 investment vehicles.
Q3. Recognizing that all gains on their investments were unrealized, calculate the before tax portfolio HPR for their 4 vehicle portfolio during the past calendar year. Evaluate this return relative to its current income and capital gain components.
Q4. Use the HPR calculated in question c to compute the Jensen's measure (Jensen alpha). Use that measure to analyze the performance of their portfolio on a risk adjusted, market adjusted basis. Comment on your finding. Is it reasonable to use Jensen's measure to evaluate a 4 vehicle portfolio? Why or why not?